When valuing companies, investors have a plethora of ways to measure the amount of money a company makes. Free cash flow, EBITDA and net income are just three of the most popular ways to value non-financial companies. In this article, we will look at the pros and cons of using each and attempt to understand our preferences for using free cash flow and EBITDA.
Net Income
Net Income, or GAAP earnings, is the official and most widely used and reported metric for company profits. Net income is based on accrual accounting, which means that revenue and expenses are recorded when they are incurred, not when the cash is actually exchanged.
Because accrual accounting is used, it means that large capital expenditures and fluctuations in working capital are usually smoothed out. This makes it easier for investors to track the trajectory of a company’s profits and makes comparisons between different years easier. However, net income has many downsides.
Because it is prepared on an accrual basis, it is easy to manipulate and prone to fraud. The history of the stock market is littered with many high profile public companies like Enron, WorldCom, Sunbeam and others who inflated earnings through accounting fraud.
Net income may also be affected by many non-cash charges, such as restructuring costs, and the write down of previously acquired assets. Companies have responded to this by frequently preparing and disclosing non-GAAP measures of profitability. While this can sometimes be helpful, it can also be prone to abuse. Indeed, the SEC has recently announced its going to start to crackdown on companies use of non-GAAP financial measures and how they are presented to investors.
Because of these flaws, we rarely use net income when doing valuations. We have found there are much better metrics to use when valuing companies.
EBITDA
EBITDA, or Earnings Before Interest Taxes Depreciation and Amortization, is often derisively referred to by the accounting profession as earnings before all the bad stuff. Indeed, on the surface it makes no sense. Why should you take out interest expenses and taxes, which are real cash charges? Although depreciation and amortization are non-cash charges, they represent, with varying degrees of accuracy, the costs a company will incur to replace its property, plant and equipment, along with other intangible assets. Thus, you would think they should be accounted for somehow and not just stripped out.
The Wall Street logic for using EBITDA is that a given company's interest expense is the result of the financing decision the company made, not a reflection of the underlying earnings power of the business. Likewise, a company’s tax rate is controlled by the government or governments where it does business, and again does not reflect the underlying business. Depreciation and amortization are accounting decisions (e.g. does management say an asset has a five year useful life or a six year useful life) and may vary between companies, auditors, accountants and management teams.
Because it attempts to get to show a company’s underlying earnings power by stripping out some things beyond the company’s control, it is frequently used for comparisons between similar companies in similar industries. Indeed, one of the most frequent uses of EBITDA is in valuations done in banker’s fairness opinions that are part of the merger and acquisition filings with the SEC. Mining these merger documents can be a great source of private transaction data to use in valuing companies you are interested in. EBITDA multiples are also frequently found in news and press releases for transactions involving private companies. It is this source of private market comparables that make EBITDA useful.
Free Cash Flow
Free cash flow is the truest measure of what a company earns. It is the amount of cold hard cash that the company made that year. It has many advantages over accrual accounting based metrics such as net income and EBITDA.
Free cash flow is the hardest number for fraudsters to manipulate. For example, while Enron was reporting profits based on GAAP earnings, the company actually was generating negative free cash flow a majority of the time. Nevertheless, hard to manipulate does not mean impossible. For example, in countries with less robust auditing procedures and a more corrupt banking system it can be possible. There were many fraudulent Chinese small cap companies during the infamous “Summer of 2011” that were found to have reported false operating cash flow numbers and false cash balances. In the US and other developed markets, this is less of a problem, but investors should always be on guard for fraud.
Free cash flow also tends to be very lumpy. Year to year swings in working capital needs and the timing of payments to and from vendors and customers can mean big swings in operating cash flow numbers. The timing of large capital expenditures can also make free cash flow numbers hard to analyze. A company may spend tens or hundreds of millions on a new manufacturing facility, reducing its free cash flow and then, when the project is complete and the capital expenditures drop, the company’s reported free cash flow will shoot up. Despite all these issues, we still prefer free cash flow. However, we do several things to address some of the problems.
We exclude any changes in working capital from the operating cash flow calculation. This smoothes out some of the wild swings in working capital some companies experience. We then add back our own estimate of working capital needs based on our assumed growth rate. You can estimate working capital needs by looking at how a company’s working capital grows with sales. If we are doing a reverse DCF model where we are just looking to solve for what growth rate the current stock price implies, we generally leave working capital out of the equation. Yes, it is technically not correct but it allows us to build dozens of reverse DCF models in a short amount of time and we mainly use it as a screening mechanism.
We also adjust capital expenditure figures, if necessary. For most companies, capital expenses increase each year fairly regularly but from time to time, you may find a year two with abnormally high expenses associated with a large new project. When you encounter something like this, you will need to do some more research. If a large one-time project is indeed one-time, you can exclude it from your projections. Odds are it will not be one time and these large projects will be things the company needs to do every five, ten, or fifteen years in order to stay competitive. In that case, you can average out the cost of the large project over its estimated lifespan. Basically, you are treating it the same way you would under accrual accounting.
Conclusion
Every measure of company profit has its advantages and disadvantages. We like free cash flow the best because we feel it has the most advantages and we can make our own adjustments to minimize some of its disadvantages. We also showed how EBITDA and computing net income can be useful as well.
Start a free 7-day trial of Premium Membership to GuruFocus.
